From THE HINDU group of publications
Sunday, May 28, 2000


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Stock Index futures: A snapshot

Anup Menon

TRADING in stock index futures contracts was introduced by the Kansas City Board of Trade on February 24, 1982.

In April 1982, the Chicago Mercantile Exchange (CME) began trading in futures contract based on the Standard and Poor's Index of 500 common stocks. The introduction of both contracts was successful, especially the S&P 500 futures contract, adopted by most institutional investors.

What is a stock index futures contract?

Stock index futures are traded in terms of number of contracts. Each contract is to buy or sell a fixed value of the index. The value of the index is defined as the value of the index multiplied by the specified monetary amount. In the S&P 500 futures contract traded at the Chicago Mercantile Exchange (CME), the contract specification states:

1 Contract = $250 * Value of the S&P 500

If we assume that the S&P 500 is quoting at 1,000, the value of one contract will be equal to $250,000 (250*1,000). The monetary value -- $250 in this case -- is fixed by the exchange where the contract is traded.

Mechanics of futures trading

Like most other financial instruments, futures contracts are traded on recognised exchanges. In India, both the NSE and the BSE plan to introduce index futures in the S&P CNX Nifty and the BSE Sensex. The operations are similar to that of the stock market, the exception being that, in index futures, the marking-to-market principle is followed, that is, the portfolios are adjusted to the market values on a daily basis.

Depending on the position of the portfolio, margins are forced upon investors. The other important aspect of index futures is that the contracts are settled on a cash basis. This means it is impossible to make actual delivery of the index. The difference between the cash and the futures index on the date of settlement is the profit/loss for the players.

Why buy index futures?

What is the rationale behind using index futures? Academic literature on the subject shows that, in some cases, the introduction of the index futures has actually reduced the volatility in the underlying index. The theory behind this is interesting.

Technical analysts thrive on their ability to predict the movement of the broad market indices. However, as they cannot trade the index, the normal practice is to try to capture a relation between the index and individual stocks. The introduction of the futures contract on stock indices gives them the opportunity to actually buy into the components of the index.

The other important use of stock index futures is for hedging. Mutual funds and other institutional investors are the main beneficiaries. Hedging is a technique by which such institutions can protect their portfolios from market risks. There are three different views in the literature on the nature and purpose of hedging:

* Risk minimisation.

* Profit maximisation.

* Reaching a satisfactory risk-return trade-off using a portfolio.

Historically, stock index futures have supplemented, and often replaced, the secondary stock market as a stock price discovery mechanism. The futures market has heralded institutional participation in the market with increased velocity and concentration on stock-trading.

Programme-trading and index arbitrage are necessary for an efficient and thriving futures market. However, on the flip side, these strategies have increased the risks associated with stock specialists. The increased concentration, the velocity of futures trading, and the resultant increase in volatility in the stock market, may have a long-term impact on the participation of individual investors in the market.

However, index futures provide investors an efficient and cost-effective means of hedging and significant improvements in market timing. The introduction of index futures need not necessarily be bad for the capital market, so long as proper checks are in place to prevent unwarranted speculation.

Section  : Opinion
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